Industry Figure Tom Chappell

From This American Life, the first explanation of the sub-prime mortgage meltdown that finally made me understand why it happened. The short answer: too much money chasing too few good investments (operating, I can’t help but add, in a lax regulatory environment).

It’s a gripping story, filled with debauchery, jargon, and really, really bad math:

A mortgage-backed security… is a pool of thousands of different mortgages. These are all put together, and divided into different slices — Jimmy’s word, tranche: “tranche” is just French for slice.

Some of these slices are risky, and some are not.

OK. A CDO is a pool…of these tranches…a pool of pools.

And Jim, and most companies like his, weren’t buying the top-rated tranches, the safest ones, the AAA’s, they were buying the lower-rated stuff, the high-risk stuff. Jim’s company bought tranches that came from [Glen's] company, the guy who hung out at nightclubs, with B-list celebrities, the guy who said he was selling mortgages to people who didn’t have a pot to piss in.

There’s another term the industry uses — this is not a joke — they call these lower-rated tranches “toxic waste.” They’re so high-risk, they’re toxic.

And so basically a CDO is sort of a financial alchemy: Jim takes this toxic stuff, these low-rated, high-risk tranches, puts them all together, re-tranches them, and…Presto! He has a CDO whose top tranche is rated AAA: rock-solid, Good as Money.

If this seems too good to be true to you, you’re in good company. Guys like billionaire investor Warren Buffet said the very logic was ridiculous.

But back in 2005, 2006, the Global Pool of Money? They couldn’t get enough of these things. And the CDO industry was facing the same pressures everyone else was, at every other step of this chain: to loosen their standards, to make CDO’s out of lower and lower-rated tranches.

This is Jim’s partner…

“Actually, in 2005, already, we had an internal debate, here, because there were two banks coming to us, saying, ‘Why don’t you do a deal with us? — BBB securities — and, uh, you get paid a million bucks in management fees per year.’ Very clear, just like that, in 2005. And…we declined those deals, we said, ‘We just don’t believe that those BBB assets are Money Good. We don’t think they’re well-underwritten, and we think that if we do a CDO of those, that’s going to blow up completely. We were a little early in ‘05, by not wanting to do those deals, and people were laughing at us, to be honest, to say, ‘Well, you’re crazy. You’re hurting your business. Why don’t you want to make…per-deal, you could make a million dollars a year.’”

“And did somebody do that deal?”

“Absolutely! Everybody!”

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…by late 2006, the average home cost nearly four times what the average family made. Historically, it was between two and three times. And mortgage lenders started to notice something they’d almost never seen before: people would close on a house, sign all the papers, and then default on their very first payment. No loss of a job, no medical emergency: they were under water before they even started.

And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history…popped.

Listen to the entire show at This American Life:
“The Giant Pool of Money”
May 9, 2008